Index fund investing has dangers

Zoomer | January 1st, 2006

If you’re one of the growing number of investors who have decided to put your faith in index funds, the last week of July must have tested your resolve.

The TSE 300 took a whumping, falling 4.6 per cent over five trading days, with the big 353 point loss at the end of the week adding an exclamation point to the tumble. But the culprit behind it all was one stock – Nortel Networks, which carries such a huge index weighting that its fortunes alone largely determine the direction of the TSE 300, 60 and 35 indices.

The week was not a good one for Nortel. First, talks about a $100 billion dollar deal with Corning were called off. The market didn’t like that, and punished the stock. Then Nortel turned around and announced it would pay US$7.3 billion to buy Alteon WebSystems Inc. which produces routers for the Internet. Investors didn’t much like that one either and hammered both stocks. Net result: Nortel shares lost $11.50 on the week, dragging the TSE indices down with them.

Tracking funds respond

Index funds which track the TSE responded predictably. BMO Equity Index Fund lost 4.5 per cent, CIBC Canadian Index Fund lost 4.6 per cent, Green Line Canaan Index Fund dropped 4.43 per cent. In other words, all were within two-tenths of a point of the drop in the TSE 300, as you’d expect.

But here’s the kicker. The average Canadian equity fund only lost 2.6 per cent during that hectic week, according to figures published in The Globe and Mail. So even mediocre managers beat the TSE 300 by a full two percentage points on the week. Some funds (those not heavily into Nortel) actually made modest profits over the five days, such as Ivy Canadian which posted a small 0.1 per cent advance.

One stock-huge impact

These events highlight the danger of relying solely on index funds in a small market like Canada, where one stock has such a huge impact on results – positive or negative. When Nortel does well, the index funds look terrific and they’ll outperform most actively managed Canadian equity funds. But when Nortel does badly, we see the opposite effect as we did last week.

(In case you aren’t familiar with the terms, actively-managed funds are those in which a manager or team selects stocks for the portfolio, using whatever style and criteria they choose. Index fund portfolios simply reflect those of the index they track.)

To my mind, index funds work much more effectively in a well-diversified market. A fund based on the S&P 500 is much more reflective of the fortunes of the broad U.S. market than one based on the TSE 300 will ever be, because of the extreme weighting of a stock like Nortel.

If you have become a fan of indexing, take that into account in constructing your portfolio. In the case of the Canadian market in particular, I recommend having no more than a 50 per cent weighting in an index fund (and 25 per cent is better) with the balance in carefully chosen actively managed funds.

(Adapted from the Internet Wealth Builder, a weekly e-mail newsletter published by Gordon Pape Enterprises Ltd.)